Tuesday, May 26, 2009

An alternate history that I find interesting is a scenario where, in 1947, the British kept one city in India - e.g. Surat. This is analogous to the British control of Hong Kong in China after the communist revolution.

Why is Surat interesting for such an analysis, and not Bombay? It sounds too implausible for free India to have tolerated colonial rule for Bombay. A solution like Hong Kong, Macao or Goa for a less important place is more plausible. The other reason why Surat is of interest is that before Shivaji sent the merchants of Surat scurrying to the safety of British-controlled Bombay, Surat was the commercial capital of the West Coast. So there is perhaps some natural geographical advantage of that location.

If the British had run Surat in the fashion that they did for Hong Kong, how might this have changed India's trajectory? The analogy with Hong Kong is straightforward. In this scenario:

Surat would have become a place with a market economy, with strong public goods of law and order, judiciary and legal system.

When India embarked on socialism, this would have been a place for people and capital to go to. Some of the brain drain and capital drain that India suffered to locations all over the world would have instead gone to Surat.

Surat would have then become a key mechanism for India to plug into globalisation, for trade in goods and services and for financial services.

When India started stepping out of socialism, a good deal of institutional capability, human capital and financial capital would have been ready at hand to help get the mainland going again.

When a country wants to undertake institutional reform, it is quite useful to have `regional role models' (a term drawn from the World Bank's East Asian Miracle book). India unfortunately has few regional role models other than the good work done in Sri Lanka on trade liberalisation before the war, and the work done in Bangladesh in microfinance; this is in contrast to East Asia where each country is able to pick and choose from regional success stories in any area of reform. If Surat had been a Hong Kong, then institutional arrangements there would have been a natural starting point for thinking about legal, regulatory and institutional development in India. This would have given faster institutional evolution and thus growth in India, once India wanted to actually do institutional reform.

The last point is a bit speculative. Suppose Surat was a vibrant outpost of good institutions and laissez faire, while India was headed off into a bad institutions and dirigisme from the late 1950s onwards. Would the very existence of a visible alternative have modified India's trajectory? It is easy to think that from the early 1990s, when India was getting interested in reintegrating into the world economy, and in building institutions, that a Hong Kong would have helped. But look back even before that; would India's long descent have been reduced or even averted by having a counterpoint? We know that in the Chinese case, they had Hong Kong and still suffered from the disasters of the cultural revolution. But in a functioning democracy with freedom of speech, the power of ideas and impact of information is greater.

In summary, if you think that China's incredible economic success was aided by having laissez-faire Hong Kong handy, then in this alternate history, a similar evolution for Surat would have helped India.

I recently came across similar arguments being made by Paul Romer. He uses the term `Bridge Cities' for such cities, which can help speed up the development of the host country.

Fallout of hostility towards bonuses to AIG employees

It is also worthwhile to note that the AIG bonuses were contractual obligations of AIG, and that most of the folks who received them were working on a $1 salary, cleaning up after the ones responsible for the mess were fired.

A rapid recovery is unlikely

Some differences with your assumptions, though I would agree with the overall conclusion.

The US adminstration will not need to go back to the Senate to ask for more money to recapitalize banks. The original TARP money was created as preference shares. By sleight of accounting, converting these to ordinary shares achieves re-capitilisation. Secondly, the political environment has tilted in what, with hindsight, seems obvious - with Congress claiming that TARP money gives them a right to dictate to TARP banks. This is actually wrong - the US doesn't need to regulate the banks who are drowning, those banks are unlikely to do the same stupid things. It needs to regulate the banks who are now healthy and are going to rush in to do the stupid things that (they believe) made money in the past. However, the practical impact is that US Banks are trying as hard as they can to repay TARP money.

This doesn't fundamentally affect your analysis though, because European banks have not yet taken the writeoffs that they need to, so the basic point remains, sort of - that banks will be undercapitalized.

I fail to see why you think that there isn't the political will to effect bank regulation.

About pt #2, that is the reason for the stimulus package and near zero interest rates. That doesn't neccesarily mean that the economy is going to bounce back right away, just that the point that you make is well understood by policy makers, who are attempting to act against it.

About pt #3, mostly agreed, but my assumption is that the hugely lower factor cost of commodities, especially oil, is going to help.

The big change in the S&P 500 reflects a fundamental change in the pricing of risk (or risk averseness). One has to be wary of drawing conclusions from the price movements. Again, I mostly agree with the statement, but not sure that the conclusion directly follows from that data.

18 May 2009 is the reverse of 17 May 2004

We were tracking SGX NIFTY all through the morning, and not very surprisingly, the volume turnover was one of the lowest in NSE. To the tunes of 3k crore.

Around 90% which makes around 2700 crores was in FNO and the rest was in cash.

Very canny players could have seen a decisive move if they would have followed the huge 3300 PE activity on Friday. Till the last week, open, 3400PE was the hedge everybody was working on, yet on Friday, masses started becoming increasingly bearish.

On Friday, in a rare phenomenon, although the underlying NIFTY kept on rising,Calls rose, [Smart Money effect] and Puts appreciated as well[partly straddles, partly bearish bias]

Wednesday, May 20, 2009

Writing in Business Standard today, Surjit Bhalla has a table of the vote share of the CPI and the CPI(M) put together. I thought it would be useful to see this data as a time-series, so here is the result:

Click on the graph to see it more clearly. Each circle is a data point. The dashed line is a (robust) regression of the Left voteshare on the time trend, with a shift in the intercept in 1991, reflecting the fall of communism. As we can see, the fall of communism seems to have gone along with a loss of vote share of 1.3 percentage points for the Left.

The latest result is a bit worse than the trend line might have suggested: tactical factors went a bit against the Left. At the same time, the CPI and CPI(M) leadership can take heart: the latest result is not all that far from the historic decline of the left, so this does not suggest that the leadership made particularly large tactical errors. What they are perhaps up against is historical forces.

The red coloured plus sign is the linear extrapolation for 2014; the slope implies losing roughly 0.13 percentage points of vote share each five years. (The statistical signifiance is weak; it's a t stat of -1.52).

Tuesday, May 19, 2009

I wrote a piece in Financial Express titled Time to question circuit breakers where I look at the costs and benefits of the existing `circuit breaker' regime on the stock market, and offer two alternatives for improvement.

Monday, May 18, 2009

Nifty

Blogger is not handling images properly. Click on the above picture to see it more clearly. If you haven't been watching the action: The application of existing circuit breaker rules meant that the market opened, went limit up, opened again, went limit up, and closed for the day.

What can be traded

Vote share

Party

2004

2009

Change

BJP

22.16

18.80

-3.36

BSP

5.33

6.17

+0.84

CPI

1.41

1.43

+0.02

CPI(M)

5.66

5.33

-0.33

INC

26.53

28.55

+2.02

NCP

1.80

2.04

+0.24

National parties

62.89

62.32

-0.57

The main story, as I see it, is that the BJP and the CPI(M) (put together) lost a vote share of 3.69 percentage points, and a vote share of 2.02 percentage points was added to INC. Of course, the above are net numbers, there must be much more going on by way of gross flows.

Sunday, May 10, 2009

Some examples

Siemens Ltd. (14 Jan 2009) sold its IT division to its parent co. and came out with a matter of fact press release to the shareholders and the rest of the world saying it's divesting a low-margin business. The consideration: Rs.449 crore, for a business that earned Rs.994 crore in revenues and Rs.73 crore in net profit, in effect valuing it at a modest P/E of 6 times. The very same business in 2007 had earned a net profit of Rs.160 crore. Why should Siemens sell this company for such a low consideration? Shouldn't they be sharing the valuation report submitted by Grant Thorton with shareholders (so that everyone knows the basis for such a low valuation), just like they send their Annual Report? [link]

Lok Housing & Constructions Ltd. (30 Jan 2009) made an announcement saying all the profits it earned in the last three years will have to be written back. Reason: Customers cancelled contracts. Action taken by the Company: It mutually agrees to let legally-bound customers cancel all the contracts, thereby saying that all the profits it reported in the last three years were non-existent! [link]

Sterlite Industries (India) Ltd. (9 Sep 2008) Board cleared a proposal to restructure its business by transferring the Aluminum business (including stakes in BALCO & Vedanta Aluminum) and the power business (i.e. 100% stake in Sterlite Energy) to Madras Aluminum (a much smaller company with a mcap of less than 1/15th of Sterlite's). Further, the proposal also included a tranfer of Vedanta's (Sterlite promoters) 79.4% stake in Konkola Copper Mines in favour of Sterlite Industries for a 1:1 ratio. The transfer of this business would have resulted in a significant jump in Promoter's holding in Sterlite Industries. Reasons for this restructuring as given by the Management: Increase in efficiency, simplification of corporate structure, and elimination of conflict of interest [link]. The point is not whether the such proposals are fair, but whether companies share sufficient information with shareholders so that they could make an informed decision on their investments. In the case of Sterlite Industries, given the scale of restructuring it was only fair on the part of the Company to disclose basic details like impact on the Profit & Loss Account, the Balance Sheet of each of the three companies, impact of increase in efficiency on profits and profitability, basis for valuing Konkola Copper Mines (one share of which was valued on par with one share of Sterlite Industries), etc. Media reports suggest that protests from certain large foreign funds and a big thumbs down to the share price pushed the management to cancel the restructuring proposal for the time being. [link]

S R F Ltd. (16 Dec 2008) announced its decision to purchase two businesses of SRF Polymers (the main promoter company for SRF) for a consideration of Rs.151.8 crore [link]. Consider this: when the announcement was made, SRF Polymers had a market cap of Rs.64 crore. Further, SRF Polymers on a cumulative basis has not made any net profit in the last five years. So why should SRF pay Rs.152 crore for a company that is a). loss making, b). has a debt of Rs.130 crore (as of FY08) and is trading at less than half that value on the bourses any which ways? Important data point: SRF's promoter SRF Polymer and SRF Polymer Investments own 45% in SRF), whereas the group's real promoters (Mr. Bharat Ram and group) own 74% in SRF Polymers.

Satyam Computer Services Ltd. (16 Dec 2008) tried acquiring two of its sister concerns Matyas Infra and Maytas Properties, offering handsome valuations for both companies with `un-related' businesses, but with high promoters (read: the Raju family's) holding [link, link]. The rest is history, but it was yet another attempt to short-circuit minority shareholders.

D L F Ltd. (23 Mar 2009) may try to do something like SRF, according to the pink papers, which suggest that the Company is planning to take a controlling stake in DLF Assets, a company owned by DLF Promoters (the KP Singh family). However, there is no official announcement or proposal that the DLF Board had cleared to this effect. But, neither have they denied the news. In a response to a related article carried in the Business Standard [link], DLF said "The Company has been looking at various options from time to time; however, no definite option has been presented to the Board so far for its Consideration". [link]. In another article dated 1 May 2009, it was reported that DLF has formed a committee of Independent Directors to look at options for DLF with regard to its relationship with DLF Assets Ltd. The Committee will look at various options, which includes a possible acquisition of stake by DLF. [link]

The big question is: Why should DLF buy a company for Rs.6-7,000 crore (as mentioned in the Business Standard report) that owes it more than Rs.5000 crore in dues? The same Business Standard report also makes a mention that the merger of DLF Assets is primarily being done to provide an exit to some of the funds who are invested in DLF Assets. Rumour or reality, we do not know. What we do know is that DLF is under significant financial stress right now. Consider this: For the quarter ended 31 Mar 2009, DLF reported a 74 per cent drop in revenues and a net loss (after adjusting for other income) of Rs.70 crore as compared to an adjusted net profit of Rs.2,141 crore in the year ago quarter.

Ray Ban Sun Optics India Ltd. (30 Apr 2008) transferred its business of distribution and sale of various luxury frames and sunglasses (that includes Dolce & Gabbana, DKNY, Ralph Lauren, Oakley, etc.), other than RayBan to Luxottica India Eyewear Pvt. Ltd. (a wholly owned subsidiary of the Luxottica group, also the promoters of RayBan Sunoptics, upon the former's instructions). Effect: Around 40% of Rayban Sunoptics' revenues came from the distribution business. And even though it was low-margin affair, it did not require any capex from Rayban Sunoptics' end, so in effect it had a fairly decent ROCE. But, yet it was transferred. After a couple of months, Luxottica de-listed Rayban by making a public offer at Rs.140 per share. Had this business included the trading business, would the minority shareholders not have received more consideration? [link, link]

Zee Entertainment Enterprises Ltd. (22 April 2009), in its quarterly results press release, announced that it has increased its holding in one of its subsidiaries, Asia Business Broadcasting (Mauritius) Limited, from 60 per cent to 100 per cent. The deal involved a cash payment of USD 56 million (approx - Rs.280 crore) to some Resource Software Ltd., valuing the overall company at USD 140 million (10 times FY09 sales and 20 times FY09 net profit). What made Zee take this step when it any which ways controlled the Company given its 60 per cent holding? Why did it not choose to repay some of its debt on which it paid an interest of over Rs.130 crore in FY09? How justified is it to pay 10 times sales or 20 times profit, given the kind of turmoil we've seen on stock markets in the last one year? What does this company called Resource Software Ltd do, who owns it, and where is it located?

Last but not the least, the mysterious case of Orissa Sponge Iron:

Here's a Company that is currently in the midst of a three-way takeover bid (bid details 1, 2 & 3), with each of the bidding companies willing to value the Company in the north of Rs.600 crore. That for a Company which in the last five years made a cumulative loss of Rs.5 crore. What's more as of 31st March 2008, it had a debt of Rs.229 crore (which I think has now increased to close to Rs.300 crore, but that's just a rough estimate based on the interest payments made by the Company in recent quarters).

So where is the profit potential? What are these companies paying for here?

Orissa Sponge has applied for iron ore mines and coal mines in Orissa and is awaiting some final leg clearances from the State Government. But, in the Annual Report for FY2008, the Company makes no mention about the size or the quality of ore in the mines (in a way that would help shareholders appraise the Company's value and compare the same with its market capitalization). There are news/brokerage reports that suggest that the DCF value of these mines could be in the range of Rs.2000-4000 crore. But, they are all based on unconfirmed reports & estimates. But, if that is indeed the case, shouldn't the Company be sharing information with minority shareholders to enable them to appraise whether to tender their shares in the ongoing bidding war for control?

Well, it seems that the takeover bid is not the only war the Company is involved in. There have been scores of reports in the media (link1, link2) about the promoters of Orissa Sponge Iron allegedly flouting SEBI's takeover code and increasing their stake in the Company at various instances in the past. Let me try to simplify things here:

Orissa Sponge Iron's total promoter holding in June 2005 was 62.7%.

This was increased to 69.3% by December 2006 (by way of conversion of warrants).

The SEBI takeover code (that was prevalent before the changes made in 2008) mentioned the following about trigger points for making an open offer:

Regulation 11(1): Between 15% to 55%, an acquirer may consolidate to the extent of 5% in any financial year without an open offer. Any acquisition beyond 5% in a financial year would entail an open offer of 20%.

Regulation 11(2): Any acquirer who is at or above 55% but below 75% cannot purchase any additional share or voting right without making a public offer for 20%.

Regulation 11(2A): Any acquirer holding above 55% but below 75% who desires to consolidate his holding may do so by means of an open offer to the extent of the applicable limit for continuous listing.

From the above it is quite clear that the Takeover code requires an open offer to be made in case there is an increase (even if by a single share) in the share holding of an acquirer who is at or above 55% but below 75%. While calculating shareholding, the rule allows the shareholding of persons acting in concert to be added up. In Orissa Sponge's case, the matter is still open for debate, but there is a possibility that the acquisition violates the Takeover Code assuming that it is proved that all the various entities which were classified as promoters were acting in concert. Further, Orissa Sponge Iron included Unitech Holdings (that held around 7-8% stake in Orissa Sponge during the aforesaid period) as a part of Promoters & Persons Acting in Concert group, despite Unitech group's claim (as stated in a clarification provided by Mr. Sanjay Chandra to DNA) that it was merely an investment in their personal capacity and that they were never involved in the management of the Company [link]. Funny, Orissa Sponge Iron includes an investor as a promoter, wonder why?

The table below indicates changes in the holding pattern for Orissa Sponge Iron and it makes for quite an interesting read.

Promoters Hldg as reported

Promoter's holdings

Addnl share /

Avg price

(%)

(shares)

(net of Unitech investment)

sale of shares (-)

(of H, L & Cl.)

Jun'05

62.70

7452849

6529949

59

Sep'05

62.70

7452849

6529949

0

53

Dec'05

62.75

7467949

6545049

15100

42

Mar'06

59.10

7736465

6813565

268516

28

Jun'06

-NA-

-NA-

Sep'06

66.00

8639485

7716585

903020

24

Dec'06

69.31

10049485

9126585

1410000

28

Mar'07

-NA-

-NA-

Jun'07

62.81

9106865

9106865

-19720

34

Sep'07

62.71

9093385

9093385

-13480

72

Dec'07

45.07

9013628

9013628

-79757

500

Mar'08

43.80

8759459

8759459

-254169

444

Jun'08

43.80

8759459

8759459

0

239

Sep'08

43.80

8759459

8759459

0

229

Dec'08

41.51

8301249

8301249

-458210

105

Mar'09

48.98

15301249

15301249

7000000

143

So where do all the aforesaid instances leave the minority shareholders?

Quite predictably, they remain at a serious disadvantage vis-a-vis the promoters. Promoters may claim that since they own a majority stake in the Company their interest is equally (or more) affected than those of the minority shareholders. Maybe, the argument has some merit. But, are the minority shareholders so unimportant that Company's do not even share details & justifications for large and important transactions like hiving-off of business units (as was in the case of Siemens, Rayban, et al) or restructuring of businesses (Sterlite) or ownership of strategic assets whose value is significantly greater than what reflects on the Company's books (Orissa Sponge Iron's mines)?

What can we do?

What the regulators need to do is make it mandatory for listed companies to share key material information that relates to important transactions like Business/Capital Restructuring, Scheme of Amalgamations, Purchase/Sale of Assets/Investments to related companies, etc. Usually, in such cases various reports are prepared, viz. a detailed Scheme of Arrangement/Amalgamation (to be submitted to the High Court) or detailed valuation reports (prepared at the behest of the Company by external agencies). Companies should be required to share these with their shareholders just like it is mandatory to send Annual Reports.

Make the transaction a transparent one, based on which a shareholder can appraise his/her investment. The way to do this was shown to us by Tata Motors, where most of the details of its takeover of JLR were made available to shareholders [link]. We may agree or disagree with Tata Motors on the merits of the acquisition or the price paid for it, but at the end of the day the investor had the option to appraise his or her investment and decide whether to stay with them or walk away.

Detailed background information of all those involved in a purchase/sale transaction should be provided. For e.g. in case of Zee Entertainment, the Company paid about Rs.280 crore to a company called Resource Software for a 40% stake in Asia Business Broadcasting (in which it already had a 60% stake). Now, what is this Company? What does it do? Where is it located? and who are its promoters? These questions are not to doubt Zee's intentions, but its a question of being transparent with your shareholders.

Companies that hold Analyst Meets (one to one or in the form of a gathering) or conference calls usually share a lot more information than that available in the Annual Report or on the Company's website. And, in most cases this information is not available to minority shareholders and is neither available in public domain. Regulators must make it mandatory for listed Companies to share the transcripts of such analyst meets and concalls in public domain and that too within a stipulated time frame. Again, just the way companies like Tata Motors do it [link].

As we come to the beginning of the end of the financial crisis, the calls for the blood of bankers have abated. There is universal agreement that the system overall was flawed, and it is unfair to burden a particular group with the full responsibility of our current sorry state.

The time has come to dispassionately step back and ask the tough question. It may or not be unfair, but is it incorrect?

Consider first the arguments for those who claim that the Bankers have suffered enough.

There was a sense of outrage that that the Bankers had not paid for their sins. This is simply not true. As a percentage of their wealth, Bankers have lost more than everyone else combined. Fully 40% of Lehman stock was held by its employees. When that stock was worth $85, the company was worth around the same, in billions of dollars. Every person in Wall Street has the right to claim that they could not foresee the collapse. The original argument was that it took mala fide intent, or stupidity to not have seen the risk. It turns out that stupidity was the right answer, since every idiot on Wall Street was in fact heavily invested in - you guessed it, Wall Street.

Which brings us nicely to point 2. The idiots could not be held responsible, since there was not deliberate fraud. There is today only a perplexing cloud of sub moronic decisions. How, is everyone asking, could we not have foreseen this ? Naturally, we forgive ourselves, and having done that, find it easy to extend the forgiveness to Wall Street. They could hardly be held responsible for the wrong decisions. After all, we made them too!

Finally, we all would like to look at who else we could hold responsible. There is a popular cry that Rating agencies should have done more, or that the entire process of Ratings is intrinsically flawed. Regulatory agencies are also very popular invitees to the whip-them-all parties. Finally, what about the consumer, the buyer of gas guzzling Hummers, the takers of sub-prime loans to purchase houses three sizes too big? Surely, some of the pie, humble or otherwise, belongs to him as well.

These arguments are not unjust, but unfortunately they miss the point. This is not a bad thing - it shows our intrinsic humanity. It takes a special kind of cruelty to turn away from justice for the past and coldly consider what is best for our future. But it must be done. "The greatest good of the largest number" is a disgusting motto, but we it does help in analysing the issues.

I will get to the inconvenient truths, but first let me speculate about why the Bankers lost so much money.

<nasty on>The reason that the Bankers lost so much of their personal money was that they were all overpaid, and behaved exactly like people do when they come into money that they know they haven't earned. They throw it into the riskiest earnings streams that they can find. That comforts them, because if they lose the money, well then, they did not do such a bad thing after all, since they didn't take the money home with them. And if they win, well then, this time the money was made by them, so that feels good as well! <nasty off>

Well, that was nasty, but my personal belief in this comes from the incidence of Wall Street Bankers in Las Vegas during the boom years. It really doesn't take too much intelligence to know that you are playing against the house, so why do such highly educated and well paid people - which probably means that they are intelligent - keep playing these games?

To come to somewhat more factual matters, the arguments for letting Ken Lewis and all the other CEOs "pursue other interests" are as follows.

The current incumbents cannot effect the change we need. It is sad but true that it is only after Obama won the presidency has it become acceptable to admit that it was a mistake to give Bush carte-blanche in Iraq. Only Senator Edwards had the courage to admit that he made a mistake, and in retrospect, it may be because it was one of his smaller ones :) The current lot will go right back to making original sin #1, forcing really intelligent people to think like idiots because of misguided compensation structures.

Which bring us to point #2. While it is probably correct to absolve the CEOs of fraud, it would be incorrect to absolve them of stupidity. One has to assume that they have blundered, and it would not be right to not hold them accountable for their blunders. In this case, by kicking them out.

The last and final point is simply a rebuttal of the desire to make major changes to the infrastructure, or to the nature of human beings at large. It may or not be feasible to make major changes to the infrastructure and social polity within which Wall Street operates. It is simply not the better answer. We don't need change around Wall Street, we need it in Wall Street. The best way to effect that change is change the players, not the environment within which Wall Street operates.

The last point is the coldest of them all, because it makes no bones about asking Ken Lewis to lose his job so that we can get on with our lives without having to wait 10 years for a new world order to come into place. But it is also the most important. It is simply the most practical decision to get a new broom to sweep clean.

Friday, May 08, 2009

I remember not so long ago, when the only thing that traders in India could think about was individual stocks. At the time, it was extremely difficult to get them interested in macro underlyings.

I find it quite striking that now, the top underlyings are Nifty (i.e. Indian macro), the INR/USD (i.e. Indian macro), mini Nifty (also Indian macro) and Bank Nifty (an industry and not an individual security). I find the sophistication of industry analysis that's now found in India to be a big step away from the way things were a few years ago, when there was only security analysis and no industry analysis.

The biggest things in modern finance are macro underlyings and not individual companies or commodities. I feel that while this transformation has taken place in trading, there is still some distance to cover in terms of bringing macroeconomic thinking into the hands of the people trading Nifty. People who trade currencies and interest rates explicitly think macro, but most of the people who trade Nifty don't seem to do this explicitly.

I remember a long time ago, when equity derivatives were still something to argue about in Indian public policy debates, I used to have a vivid sense that individual stock futures would readily tap into the capability for leveraged trading on individual stocks that existed because of `badla'. But shifting from that to index derivatives was going to require new ways of thinking. You might find this article of mine, from 1997, to be mildly amusing. Today it's all obvious, but back then it was not.

Market microstructure theory has some important messages about why macro underlyings become more liquid than securities issued by firms. With firms, there is always more asymmetric information, which leads to bigger spreads (or bigger impact cost). With macro underlyings, informational asymmetries are smaller, which gives better liquidity.

Wednesday, May 06, 2009

The Growth Commission organised an interesting meeting at Harvard recently on Financial Crisis and its Impact on Developing Countries' Growth Strategies and Prospects. These materials have come up on the web: day 1, day 2.

Saturday, May 02, 2009

There is a somewhat cliched old diagram that shows what we're supposed to do when a bank gets into trouble. There are some nervous questions about this these days, but I still think the essence holds:

Solvent but illiquid

When a bank gets into trouble, the first question to ask is: Is it insolvent or is it just illiquid? If it's merely illiquidity, then central banks should provide temporary liquidity support to a fundamentally sound firm. This liquidity backstop has always been a crucial role through which governments make the concept of a bank possible. The moral hazard involved here is controlled by making this liquidity support extremely expensive, so that banks should think thrice before using it.

These days, countries generally separate out the function of monetary policy, which is placed at an independent central bank, from the function of financial regulation and supervision which is placed at a financial regulator. In this case, a proper interface between the two agencies is required. To some extent, liquidity support is about merely having a central bank window where good quality assets are repoable at a penal rate (and with haircuts reflecting collateral risk). To some extent, this requires the financial regulator to make a call on whether a bank is merely illiquid or insolvent.

Insolvent but small enough to fail

When a bank is insolvent, there are two cases. If it is a small firm, then it should just get wound up. The depositors should get paid based on agreed-upon rules of deposit insurance. The US has an agency named the FDIC which has done a great job of closing down dozens of banks in the current crisis. The UK did not have such a capability, and after the crisis, this has been created.

India does not have this capability (even though technically, a deposit insurance corporation exists). A key task in India's financial sector reforms is that of setting up such a capability, to swiftly close down a bank, and pay depositors upto Rs.100,000 per person. Chapter 6 of Raghuram Rajan's report is the best blueprint out there about setting up a deposit insurance corporation, and other dimensions of improving systemic risk (see `V. Preventing Crisis and Dealing with Failure').

In earlier years, we used to think that if deposit insurance did not exist or was set very low, then it would help induce greater market discipline. Depositors would tend to avoid banks which were fragile; their cost of funds would go up. Financial weakness would yield reduced profits and generate incentives to shore up the firm. I would have liked to live in that world. Sadly, real world politics just does not allow banks to go down calmly under such circumstances. Hence, as Jim Hanson and Gerard Caprio used to say: "There are only two kinds of deposit insurance. That which you knew you had, and that which you did not know you had." Hence, I think we have to all give up on designing a world with miniscule or no deposit insurance. A value like what we have in India, of roughly 2x of per capita GDP, seems quite adequate to me.

The troublesome zone

That leaves the troublesome case of insolvent banks which are too big to fail. In India, that would be a firm like SBI or ICICI Bank, where closing the firm down is not easy in the short term. What is the alternative?

Do nothing? There is a full consensus that the worst strategy is the Japanese approach: of doing nothing, of a banking regulator which aids and abets banks in violating equity capital requirements, and hopes that growth will take care of the problems. The big word `forbearance' is used to convey banking regulators who don't insist on banks being adequately capitalised. In this strategy, the problems of banks weigh down the economy. Both the banks and the economy get into a protracted malaise.

The good bank / bad bank strategy. The traditional model, which has been used in many countries, is to partition the ailing firm into a "good bank" and a "bad bank". First, the government takes over the firm (i.e. the private shareholders get returns of -100%; they get expropriated). The healthy assets and businesses are put into the "good bank" and the difficulties are concentrated into the bad bank. The good bank is quickly privatised - typically at a good price because it is a clean and healthy business. The bad bank is put under public sector management. The distressed assets are slowly processed, and some taxpayer money gets used to close it down.

In India, this strategy was used with UTI. UTI was carved up into one piece (what is now UTI MF) which should go on to become a modern financial firm much like ICICI or HDFC, and all the trouble was kept in SUUTI. There are two areas where this was not a textbook good bank / bad bank strategy at work: (a) Good UTI was not swiftly privatised, and (b) Bad UTI did not have complicated NPAs which required resolution.

The `bad assets' often yield more value when patience and care is applied to working on them. In the present crisis, the consolidation of home loan assets is likely to create significant value. By and large, US home prices have dropped 40%, but home loan securities have dropped 80%. A good part of this gap, of around 40%, can be captured by consolidating the home loans and working on them.

The good bank / bad bank model is nice to describe, but it's actually very hard to do in practice. A key difficulty of this approach is the management difficulties associated with a public-sector dominated process of sifting through the assets, auctioning off the good bank, and hands-on running the bad bank until it is closed down. This requires immense governance capacity on the part of the public sector.

As an example, there can be political pressure upon a public sector bad bank, to not evict homeowners who have defaulted on their home loans. Or if the bad loans have been given to industrialists, then they would lobby with politicians to get the (public sector) bad bank to not vigorously enforce on the bad debt. There are also concerns about competence and incentive: how would the public sector bring in the right employees for doing all this, and motivate them properly? It is too easy for a government to do badly on recovering from NPAs, and make up by putting more taxpayer money into the recapitalisation. And the entire good bank / bad bank model is violated if the good bank is not privatised. In a place like India, there's a danger that the private bank which is taken over will just be absorbed into the public sector and never ejected out again.

The good bank / bad bank model worked well in places like Sweden, but it's application into developing countries should be viewed with caution, since it requires governance capacity which is often not found in the third world. It's striking to see that in India, this approach was roughly used with UTI, where the assets in the `bad bank' were mostly plain equities. There was no complex NPA resolution required.

With situations like Indian Bank, the good bank / bad bank model was not used; instead the government just put a lot of equity capital into Indian Bank to pay for the bad loans. Or, consider Global Trust Bank -- there was no process of good bank / bad bank followed by privatisation of the good bank: Global Trust Bank was just merged into a public sector bank, we grew the footprint of the public sector, and that was that.

A new private-sector driven alternative to the good bank / bad bank model

An interesting feature of the present crisis is that this model has, by and large, not been used. Instead, the strategy being followed by the US Treasury, termed `Public-Private Investment Program' [link, link], runs through the following steps:

Housing assets of banks will be sifted and organised (on a voluntary basis by the distressed banks) and put up for auction.

A private investor will put up roughly $6. The government will come in as an equity investor with a 50% stake, bringing in another $6. The FDIC will enable debt of $84. With this $100 in hand, the private investor will buy a pool of home loans (at the auctions).

These assets will go off the balance sheet of the bank.

The private investor will then handle the assets until resolution.

In this arrangement, the private investor has very strong incentive to recover more than $84 out of the pool, which is required to repay the debt, since he keeps half the upside above that. This approach harnesses the creativity and hunger of the private sector in order to workout the bad assets. This is likely to work better than relying on a public sector dominated approach. And yet, the government keeps half the upside after the debt has been paid off.

What will force the bank to sell off bad assets? A banking regulator who does not engage in forbearance, and a government that holds out a recapitalisation strategy. These two, put together, would generate incentives for the bank to honestly identify bad assets and sell them off. But there is complicated game theory in this. If the bank is too big to fail, then the threatpoint of a regulator is actually limited. The government needs levers to bring into play in the event that the bank sits tight and refuses to cleanup its balance sheet by selling off bad assets. And if a recapitalisation strategy is not articulated, the bank will not like doing trades which visibly generate massive losses on the P&L.

A key strength of this approach is that nationalisation or quasi-nationalisation is avoided. The big banks sell assets through auctions which should, hopefully, convert them into good banks. The "bad banks" are basically private equity funds, where the private sector provides the hunger and the government enables their financing.

The private sector will do a better job of recruiting and incentivising people to work for these `bad banks', and they will vigorously recover value from a portfolio of bad assets, without the risk of political interference.

Let's think write down some imaginary values to fix the intuition. Suppose there was a bank with total assets of Rs.100, equity capital of Rs.10 (i.e. 10:1 leverage), and suppose it had found itself holding Rs.50 of non-performing assets. These bad assets are auctioned off; suppose the auction-discovered price works out to Rs.25.

First, let's analyse what happens to the private equity funds which buy the bad assets. On average, private equity funds are unlikely to lose money in this situation where they have voluntarily picked the price that they would bid. Hence, there's a good chance that the private equity funds will manage to recover more than the Rs.25 that they put up in the auction. With this, the government guaranteed debt (that was taken up by the private equity fund) gets repaid, and maybe the government makes some money by virtue of being a 50% shareholder in these funds.

That leaves the bank. It has made a loss of Rs.25 owing to the auction. This blows through the original equity capital of Rs.10. A recapitalisation strategy is essential. Suppose the government comes through with preference capital of Rs.25 at an interest rate that's higher than the average cost of financing of the government. Now the bank faces the burden of paying off this debt gradually. But it's doing so from a fundamentally solvent position.

If all these things work out correctly -- the preference capital that the government puts into the bank is serviced properly, and the private equity fund manages to repay on the government-guaranteed debt that it has taken up, and the private equity fund even pays the government something for the 50% equity stake -- then all this involves no cost to the taxpayer.

PPIP is not yet working properly in the US. And yet, at the level of this broad presentation, it appears to have many interesting features. I think it constitutes an important alternative to the good bank / bad bank model. It is particularly relevant in developing countries, where the governance capacity required to make the good bank / bad bank model work is harder to find.

Relationship to the Indian strategy of ARCs as fund managers processing bad debt

I find some fascinating similarities with other aspects of debates on handling bad assets of banks. In 1999-2001 there was a lot of pressure, in India, to do as the East Asians had after their banking+currency crisis: to create an `Asset Reconstruction Company' in the public sector with Rs.10,000 crore of capital, have it issue Rs.90,000 crore of government guaranteed bonds, and use this money to buy Rs.200,000 crore of NPAs and thus cleanse the banking system of this burden. This public sector `ARC' would then spend a decade on doing resolution of bad loans, while the banking system would get back to giving out new bad loans.

I think India did well in avoiding this model. Instead, the strategy used was to remove the legal/accounting/regulatory bottlenecks through which specialised firms like ARCIL could come about, which obtain resources from the private sector where they have to pass the market test, which voluntarily buy bad assets that are voluntarily sold by banks, and then use SARFAESI to get a good return on capital. Government put zero money into ARCIL. ARCIL and its ilk look a lot to me like the private equity funds described in the structure in the US above. The key difference is that while in India, the government has had capital controls which hinder the fund-raising of these firms, in the US, the government is supporting the fund-raising of these firms through guarantees on debt and half of the equity financing.

Friday, May 01, 2009

Readings of the day

It has now become somewhat clear to any reader that thinks beyond the print a bit, that Satyam was a black-money laundering machine for various Hyderabad politicians.

Question: could there be other companies doing the same? Software is notoriously hard to audit. no export invoices etc. all vaporware (software). Maybe wireless telephony (eg airtel, spice etc) could be in the same boat?

Signs of a thaw?

For recovery of the financial markets, there are events that would lead the credit spreads e.g. willingness of banks to repay TARP. They do have to be used carefully. While Goldman pretends eagerness for financial freedom, it is only asking to repay what it doesn't like. See comment in barrons on TLGP for more details.

thanks for the link on NYTIMES about the "great election". So True. Also, it must be pointed out, that having a demographically "young" country is very stupid to live in if you are a thinking person.

All movies are teeny bopper dandy dating oriented. All "news" is hype. There is no national "dialogue" at all. Period. Just a dinner at McD! This is the electorate. And their doting parents obsessed with their offspring are too tired to do anything else.

In short India is braindead. Except where passing stodgy exams to get "great" 12 hour jobs crunching spreadsheets in an MNC with chance to go abroad.

Fallout of hostility towards bonuses to AIG employees

Besides the FDIC bond guarantees, banks in general have been 'bailed' out via AIG. The govt. effectively gave them a new counterparty instead of AIG for free!

AIG financial products group were in the business of 'insuring' (via CDS) tranches of ABS CDOs that banks held and needed to reduce regulatory capital requirements. Sure they didn't pump money directly to the rest - and the cost of this 'bailout' will only be known once the CDS portfolio in AIG matures.

Now if they didn't capitalize, or left AIG insolvent, imagine what happens then when you have major banks looking for capital at the same time - further killing the interbank market - and this just after the Lehman episode.

To me this is a bail-out of the financial sector, but one which was needed to prevent a general economic meltdown which would then hurt households.

But naturally I think it is right to be disgruntled when you have people at Goldman Sachs offering to repay TARP funds, saying they didn't need them at the time and acting like everything would have also been cool for them if AIG was not 'bailed' out.